Countless restructuring lawyers have told me that their corporate partners are hesitant to introduce them to their firm’s troubled business clients because the “B” word might “spook” the client. I also experienced board ostrich syndrome (i.e., denial that the company is experiencing financial distress) first-hand at several points during my days in private practice. Moreover, if and when lawyers finally discuss the “B” word with a company, it most always is pitched as a last resort option.
It is against this backdrop that I recently read and considered the Delaware Chancery Court’s decision in Binks v. DSL.net, Inc. The question before the court was whether the business judgment rule protected the decision of DSL.net’s board to cause the company to incur additional debt, rather than file for bankruptcy. (For a concise summary of the case, see here.) The board’s decision was contested by one of DSL.net’s minority shareholders because the additional debt included convertible notes that, once converted, gave the lender a 90% ownership stake and the ability to consummate a short-form merger. The court ultimately concluded that the board was independent, disinterested and well-informed, and consequently protected by the business judgment rule, even under the more exacting standard of Revlon and its progeny.
I do not disagree with the court’s conclusion. (For a general discussion of when heightened scrutiny of control transactions might be warranted, see here.) Anyone who has been inside a boardroom during these types of deliberations understands the complexity of the situation; the multiple, often-competing considerations; and how even the most well-intentioned, diligent and intelligent board may make a decision that turns out to be suboptimal in hindsight. I do wonder, however, whether we are performing a disservice to corporate clients when, almost as a matter of course, lawyers and corporate executives shun bankruptcy and fail to include the chapter 11 option in normal risk management and strategic discussions.
We should be even more concerned about this approach when you consider the possible cognitive biases that might affect the board’s decisionmaking (see, e.g., here, here and here). For example, loss-framing causes individuals to be more risk-preferring when they are facing two or more choices that all present a risk of loss (see, e.g., pp. 1127-1130 here). The risk might be bigger, but so too will be the reward for the company and its shareholders, or so the thinking goes. Likewise, overconfidence and “the Lake Wobegon syndrome” can cause executives to believe that, regardless of the facts, they somehow will avoid disaster and pull their company back from the brink. (For a general discussion of cognitive biases and risk management, see here.) Decisionmaking biases and the general aversion to bankruptcy could be a lethal combination for a troubled company.